Goodbye Stock Option, Hello Restricted Stock: Microsoft Leads the Way

As you have probably know, Microsoft longer issues stock options to its employees. The decision appears to have been driven by several concerns, including disenchantment among workers whose options are not worth much because the underlying stock never rose in value, threatened changes in accounting rules that would require employers to treat stock options as a compensation expense, and the general negative sentiment of shareholders and the public towards stock options that has been reported in the business news.

In place of stock options, Microsoft grants restricted stock to its employees. Microsoft has brought renewed focus on a form of stock-based compensation that, while commonly used, has received little public attention.

What is Restricted Stock?

Under a restricted stock program, employees are granted the actual stock - not just an option to acquire the stock. The grant comes with a catch, however. The catch is that the stock cannot be sold (hence the name "restricted stock") and the company has the right to reacquire the shares (usually for the lower of the amount, if any, paid by employees for their shares or the fair market value of the shares at the time they are reacquired) if certain financial targets are not met or the employee does not remain employed by the company for a certain period of time. In the latter case, the company's right to reacquire the stock typically declines over time.

For example, a restricted stock plan may provide that the company has the right to reacquire 100% of an employee's restricted stock if the employee does not remained employed by the Company for one year, 80% if the employee does not remain employed by the company for two years and so on, so that the company no longer has the right to reacquire shares after the employee has been employed by the company for five years.

Since the employee actually owns the shares of stock, he or she will be entitled to share in dividends, if any, paid with respect to those shares. By contrast, an option holder is not entitled to share in corporate distributions until such time as he or she exercises the option and receives the shares of stock.

Pros and Cons

A restricted stock plan may help improve employee moral by insuring employees that they will walk away with something, even if the value of the company's stock does not increase in value (assuming the employee fulfills the conditions to vesting).

For example, if a company grants restricted stock for no consideration under a plan that requires employees to remain employed by the company for a certain period of time before the shares vest, the employee will generally be assured that, by simply staying employed with the company for the requisite period, he or she will have something of value (assuming the company has some shareholder's equity), even if the shares decrease in value after the grant.

However investors may complain that such a plan does not provide employees with sufficient motivation to increase the value of the company's stock. Without a doubt, we will hear this issue debated further as more and more attention is directed at restricted stock plans.

Employee Income Tax Issues - Choices Must be Made

Employees receiving restricted stock will be faced with choices that may have a significant impact on the amount of taxes they pay.

Do Nothing

If an employee who receives a restricted stock grant does not make the Section 83(b) election described below, the following rules will apply. Since stock received under a restricted stock plan is subject to being reacquired by the company, the employee normally does take into income the bargain purchase element associated with his or her acquisition of the stock (i.e., the difference between the fair market value of the stock on the date the stock is acquired and what the employee pays for the stock) until such time as the stock is no longer subject to being reacquired.

For example, assume that an employee is granted 100 shares of restricted stock, the fair market value of the stock at the time of the grant is $10 per share, the 100 shares of stock vest over five years (as described above), and the employee pays nothing for the stock. Since the stock is subject to being reacquired by the company at the time of grant, the employee generally is not required to take the $1,000 (100 shares times $10 per share) bargain purchase element into income at such time.

After being employed by the company for one year, the company's right to reacquire the stock lapses as to 20% of the shares (i.e., 20 shares). Assume that the fair market value of the stock at that time is $15 per share. The employee must report $300 (20 shares times $15 per share) as income. The same occurs in each of the following four years, assuming that the employee remains employed by the company, until the employee has reported income with respect to all 100 shares of stock.

Do Something

As an alternative to waiting and reporting income in each year as the right of the company to reacquire the stock lapses, the employee can elect under Section 83(b) of the Internal Revenue Code to report as income the bargain purchase element of the stock at the time of grant.

This election must be made within 30 days of the time of the grant. In our example, the employee would report $1,000 at the time of grant if the Section 83(b) election is made. While making a Section 83(b) election will accelerate the reporting of income by the employee (generally, the opposite of good tax planning), the employee may in fact be saving taxes by doing so.

That is because appreciation in the shares of stock after a taxpayer makes a Section 83(b) election will be taxable as capital gain (at a maximum rate of 15%), rather than ordinary income (at a maximum rate of 35%).

In the example above, if the employee does not make a Section 83(b) election, he or she reports $300 of ordinary income (taxable at a maximum rate of 35%), with respect to 20 shares, after one year. By contrast, if the employee makes a Section 83(b) election, he or she would report $200 of ordinary income, with respect to the same 20 shares, at the time of the grant.

No further reporting of income would be required at the time the company's right to reacquire the shares lapses. However, if the employee sells the 20 shares after the company's right to reacquire the shares lapses (i.e., at the end of year one, when the shares are worth $15 per share), he or she would report $100 of capital gain (i.e., $300 (the fair market value of the 20 shares) less $200 (the employee's basis in those shares which he or she acquired by reporting the $200 as ordinary income with respect to the shares at the time of grant).

If an employee expects the shares to increase in value, he or she will generally want to make a Section 83(b) election. However, an employee should not do so without first seeking guidance from a tax professional experienced with these matter. There can be drawbacks to making the election.

For example, if a Section 83(b) election is made, the employee will have to come up with sufficient cash to pay income taxes, even though the shares cannot be sold to generate such cash because of the restrictions. Moreover, if the employee forfeits the shares, he or she is not entitled to a refund for the taxes paid.

Employer Income Tax Issues - More Straightforward

The income tax rules for the employer are a little more straightforward. The employer is entitled to a deduction for income tax purposes the bargain purchase element of stock granted under a restrictive stock plan. The timing of the deduction is controlled by when the employee reports a corresponding amount in income. In the example above, if the employee does not make a Section 83(b) election, the employer is entitled to a deduction each year that its right to reacquire stock under the restricted stock plan lapses and the employee must report the bargain purchase element in his or her income.

In the first year after the year of grant, therefore, the employer in the example is entitled to a $30 deduction. A similar deduction would be available in subsequent years. If the employee makes a Section 83(b) election, the employer is entitled to a deduction for the entire amount in the year of the election. In our example, the employer would be entitled to a deduction for $1,000 in the year the restricted stock is granted.

Conclusions

While various forms of stock-based compensation have been around for many years, the focus during the dot.com boom on stock options has drawn attention away from other types of programs. Microsoft's switch from stock options to restricted stock reminds us that stock options are not the only game in town. Companies should be aware that the Securities and Exchange Commission requires shareholder approval of stock-based compensation, in the case of public companies. Both stock option plans and restricted stock plans are affected by this.

For companies, such as financial institutions, whose stock has held up relatively well in the current depressed economic environment, the need to implement a restricted stock plan may not be as compelling as for those companies that have not fared as well.

Their existing traditional stock option plan may be adequately serving its intended purpose of providing incentives to employees to increase the value of the company; and by continuing with the stock option plan, these companies can avoid having to address the concerns shareholders have had with restricted stock plans.

These companies may want to wait until after they have had a chance to review their year-end financial performance before deciding whether to implement a restricted stock plan. Another factor to consider is that, ultimately, at least all publicly traded companies will have to report the income effect of unexercised stock options on their income statements. Currently, they are only required to disclose this in the notes to financial statements.